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Feature Story from May/June 2000

Big Tent
By Howard J. Bolnick

As the financial services industry expands in scope and complexity, the professional discipline of actuaries is the one constant that can help hold it together.

The actuarial profession had its 150th birthday in 1998 when the Institute of Actuaries in the United Kingdom celebrated the anniversary of its founding in 1848. At the time of its founding, the actuarial profession shared the distinction of using applied probability and statistical techniques with only one other, somewhat less illustrious, occupation -- gamblers. And, actuaries practiced their science in only one sector of the financial world -- the nascent life insurance industry.

Over the past 150 years actuarial techniques have spread far beyond their origins in life insurance. Today actuarial approaches are used throughout financial services to address a wide variety of risk management problems. Practical applications of probability and statistics are now found in life insurance, general insurance, employee benefits, bank risk management, financial engineering and corporate risk management. Beyond these financially oriented applications, actuarial techniques are even being incorporated into problems involving large-scale capital project management and operations research.

Actuarial science has expanded far beyond its origins in life insurance, and, even beyond its recognized practice today in life insurance, general insurance and employee benefits. Actuarial techniques are used as the leading approaches to problems of modeling and management of financial risk and contingent events. However, practitioners of these now widespread techniques are not recognized as actuaries outside traditional areas of practice in insurance and employee benefits.

This dichotomy between diffusion of methods and professional recognition offers an opportunity to actuaries and to the various stakeholders, including the general public, who depend on the effective real-world applications of actuarial techniques for pricing risky financial products and assuring the solvency of risk-bearing institutions. In effect, risk management practitioners throughout the financial services industry and beyond are all actuaries.

The actuarial profession is acutely aware of this opportunity. At both the national and international levels, actuarial leaders are discussing possible futures and making plans for a closer match between the scope of application of our ideas and recognition of practitioners as actuarial professionals. In North America, the Society of Actuaries, the Casualty Actuarial Society, the Canadian Institute of Actuaries and the American Academy of Actuaries are working together to better understand the opportunity and to devise a strategy and supporting tactics to expand the profession. This work is the actuarial profession's "Big Tent" strategy.

While the actuarial profession can proudly point to the diffusion of its ideas and techniques, expanding recognition of actuaries and the actuarial profession is a major challenge. To be successful, expansion must be based on solid value to the public and to other stakeholders in industry and government.

I believe that a strong case can be made for expanding the actuarial profession. This case is built on the solid ground of historical reasons for actuaries' success. To understand the reasons for this success, we need to look at the insurance industry from which the actuarial profession arose.

Insurance Companies and Markets

Insurance companies don't function well in fully competitive markets. This statement is probably a shock to many readers, but economists have carefully studied this unusual phenomenon. Two eminent economists, Michael Rothschild and Joseph Stiglitz, captured the essence of what economists call insurance "market failure":

    "Economists generally prescribe competition as a solution for markets that do not work well. . . Insurance markets differ from most other markets because in insurance markets competition can destroy the market rather than make it work better."(Emphasis added) (Rothschild and Stiglitz 1997)

Despite the irrefutable fact that insurance markets are thriving throughout the world, Rothschild's and Stiglitz's warnings reflect real-world conditions.

The early history of life insurance is rife with market failure. Early insurance companies were prone to bankruptcy and fraud. These problems arose from conditions inherent in life insurance transactions and insurance markets.

  • Consequences of long-term contracting under uncertainty. Numerous contingencies affect the ability of life insurance companies to fulfill their promises to customers. There are external contingencies such as estimating mortality, terminations, and interest rates, and, internal contingencies such as management's competency and its trustworthiness.

    To build trust necessary for success, insurance companies must assure their customers they will perform when called upon by terms of contracts that they issue. This requires solving a fundamental problem. Somehow insurance companies must find a balance between two, often contradictory, pressures: charging adequate, yet not excessive, premiums, and, holding adequate, yet not excessive, capital.

  • Asymmetric information about management of insurance company business activities. Solving the problem of balancing premiums and capital is difficult enough even if owners and customers have equal information and are equally sophisticated. However, their relative abilities to understand contracts and operations are weighed heavily in favor of owners. This is a serious information asymmetry that makes it difficult to build trust between owners and customers.

  • Potential for adverse selection as a cohort of new customers ages. Life insurance is a long-term contract. With time, an insurance company risks losing its low-cost, healthy customers to other insurers. To avoid this problem, life insurance companies try to "lock-in" their customers by making it expensive to switch. Front-end loading deals effectively potential adverse selection. But, it also increases the need for trust between owners and customers while at the same time reducing the opportunity for customers to redress any owners' excesses.

  • Insurance market failure due to asymmetric information about the nature of insurance risks. The structure of insurance markets causes its own problem. In their seminal work, economists Rothschild and Stiglitz (1976) analyze a competitive insurance market in which customers know their own risk characteristics, but insurance companies do not have this information. This asymmetry of information between insurance companies and their customers causes market failure. In markets with asymmetric information, Rothschild and Stiglitz demonstrate that a competitive equilibrium may not exist, markets may fail to form, or markets may disband following unsuccessful attempts by companies to underwrite insurance. In addition, if markets do exist, they may have strange properties. For example, insurance may be offered to high-risk customers, but not to low-risk customers.

    To succeed, insurance companies and insurance markets must overcome these inherent self-destructive tendencies. Since insurance is simply an exchange of cash now in return for a long-term contingent promise, doing so requires building a great deal of trust between insurance companies and their customers.

Stable and Profitable Markets

Despite these serious problems, private insurance companies and viable insurance markets somehow not only exist, they flourish. The real potential for market failure has been overcome. This fortuitous outcome can be ascribed to three key historical developments in the insurance industry.

  • Mutual Insurance Companies. As we've seen, insurance companies have potential for destructive conflict between owners and customers in reaching optimal contracts. Mutual insurance companies are one means of resolving this conflict. As owners of the company, customers can trust that their best interests are the sole concern of company management. There is ample evidence in the early history of life insurance that mutual insurance companies played a significant role in the early successful development of insurance markets.

  • Insurance Regulation. State regulation of insurance companies also contributed to insurance market stability and the growth of public trust. Insurance regulation effectively manages customer-owner conflict by placing an independent third party (legislators and regulators) in a powerful position to proscribe actuarial and operation methods and to review, as needed, prices, reserves, capital and profit distribution. In the United States, the successful growth of stock insurance companies coincided with the introduction and spread of state insurance regulation in the 1850s and 1860s.

  • Insurance Company Risk Management Tools. Insurance companies have developed their own risk management tools to control the potential consequences of market failure. Risk selection, risk rating, claims adjudication, managed care, policy limitations and exclusions are all historically successful risk management tools without which insurance markets might not be stable and profitable.

    Mutual insurance companies, insurance regulation and insurance risk management tools are the means used in the insurance industry to overcome its inherent self-destructive tendencies. But form without substance cannot be effective. It's the substance behind these visible developments that we seek to uncover.

Actuaries' Professionalism

Actuaries and the actuarial profession provide the substance. History provides ample proof that actuaries and actuarial professionalism are behind mutual insurance companies, state insurance regulation and insurance risk management tools.

Most successful early mutual insurance companies in the United States employed actuaries, usually in very senior management roles; many of these companies were actually founded and run by actuaries. State insurance regulation also has actuaries behind its development. Early advocates for regulation, and the first insurance regulator, Elizur Wright, were actuaries.

Actuaries have also played a vital role in designing and operating effective insurance regulatory techniques. Finally, actuaries often developed risk management tools that have become the machinery allowing insurance companies to operate effectively in the face of potential market failure.

Actuarial expertise has been the common element that made mutual insurance companies, insurance regulation and risk management tools effective means for overcoming market failure. Why actuaries? Actuaries have the mathematical and business skills necessary for the proper application of mathematical models to solve real-world insurance market failure problems. And, perhaps most important, actuaries are trained to balance the interests of customers and owners when applying their mathematical and business skills. Balancing pricing and solvency requirements while attending to the diverse, and often conflicting, interests of owners, managers and customers underlies the professional judgment and ethic that is so basic to actuaries' success.

The success of the actuarial profession, in turn, lead to the much more visible successes of insurance companies, insurance regulation and insurance markets. By mitigating owner-customer conflict, by balancing pricing and capital needs, and, by developing effective risk management tools, actuaries have earned public trust. The singular characteristic of the actuarial profession is this implicit public trust.

The "Big Tent" Strategy

For the past 10 or so years, the Society of Actuaries has espoused an expansive vision for the future of the actuarial profession. The most recent version of this vision is for actuaries to be recognized as the leading professionals in the modeling and management of financial risk and contingent events.

This vision clearly calls for the profession to expand beyond its current recognized scope of practice in insurance and employee benefits. It easily encompasses risk management throughout the financial services industry and corporate risk management.

A vision is important for any organization or profession. Without one we have no clear idea of where we're headed. As Yogi Berra once pointed out, "If you don't know where you're going, you're not likely to get there." Realizing a vision, however, takes time and can be accomplished only if the vision makes sense to the internal and external stakeholders affected by any change.

Expanding the actuarial profession makes sense for actuaries. But more important, there's a strong argument for the value of this expansion to those competent practitioners already using actuarial techniques throughout the noninsurance financial services industry; to managers of noninsurance financial institutions; to legislators and regulators who are concerned about the viability of financial services companies; and to the general public. This argument for an expanded actuarial profession rests on there being common intellectual capital for all risk management practitioners, and on the value of professionalism.

Common Intellectual Capital

Risk management throughout the financial services industry addresses two basic questions: What is the proper price for its products, and how much capital is necessary to assure a company's solvency? Actuarial techniques provide practical, real-world answers to these questions through specialized probability and statistical techniques, using appropriate data and methods, to model the future.

Whether the actuarial method is applied to life insurance, pension plans, general insurance, managed care, banks or hedge funds, there's a common mathematical core of knowledge underlying all these distinct actuarial business applications. Describing the mathematical core is well beyond the scope of this article, but the existence of a common core can be demonstrated.

Actuaries and noninsurance risk management practitioners usually learn their mathematical skills in university. In the United States, university actuarial and financial risk management programs are developing independently. Actuarial programs have been offered at many major universities for many decades. Financial mathematics programs are a relatively new and rapidly expanding phenomenon. Masters-level programs are now available at such fine universities as the University of Chicago, Carnegie-Mellon, and the Massachusetts Institute of Technology.

In Canada, Australia and Europe, though, actuarial mathematics and financial mathematics are generally taught in the same programs, using a common curriculum. Graduates from these programs, interested in applying their skills to insurance and employee benefits, pursue actuarial credentials; students interested in applying their skills to noninsurance financial institutions don't. Many of these combined actuarial mathematics/financial mathematics programs outside the United States are taught by Ph.D.s with actuarial credentials.

There's a common understanding of the financial world that's already being taught at many universities outside the United States. This fact prompted one of the most eminent actuarial educators of out time, Professor Hans BÄhlmann, to correctly declare, "ƒwe are all actuaries."

Actuarial techniques teach practitioners to price products and to determine solvency margins. These skills are necessary, but not sufficient for the viability of financial institutions. Viability requires more than numbers. It requires the professional judgment to balance the competing needs of determining adequate, yet not excessive prices with identifying adequate, yet not excessive capital to bear risk.

Reliance on actuaries, with appropriate review by regulators, is well established in insurance and employee benefits. The actuary's role is embodied in the concept of "valuation actuary," the legally designated professional upon whom insurance regulators rely to determine insurance company solvency. Though professionalism is admittedly an ephemeral concept, a useful definition is that "professionalism signifies the formal recognition of mutual trust between the professional group and the larger public." The valuation actuary is visible public recognition of actuarial professionalism.

Professionalism in Other Financial Services

I've already conceded that there are competent practitioners applying actuarial risk management techniques to the business problems of noninsurance financial institutions. These practitioners have the mathematical and business skills needed to solve these institutions' risk management problems. However, these practitioners are not professionals -- they've not yet developed mutual trust between themselves and the larger public.

Developing a high, professional level of trust is in the best interests of these practitioners, their employers, legislators, regulators and the general public. Two recent events demonstrate this need.

  • Basle Accord on bank capital adequacy. The Basle committee sets international standards for bank capital adequacy. Recently, the committee has been studying the use of value-at-risk (VaR) models instead of historical "risk buckets," each with its own capital requirement. VaR is a widely used statistical performance measure that answers the question: What is the maximum loss a bank might incur with a specified confidence level?

    Banks often use actuarial VaR models for internal risk management. But the Basel committee is reluctant to rely on VaR and the internal bank practitioners who develop and operate these models. The committee cites concerns about the effectiveness of VaR models, the reliability of practitioners, and proper application of internal models for use in uniform and effective regulation of bank capital.

    Actuaries have overcome all these problems in the development and application of risk-based-capital models used by valuation actuaries and regulators in assessing the solvency and solidity of insurance companies. Use of actuarial models and reliance on actuaries is based on actuarial professionalism in the application of statistical models. It seems appropriate to conclude that bank VaR practitioners have a strong need for actuarial professionalism to overcome the Basel committee's reluctance to adopt VaR.

  • Long-term Capital Management (LTCM). LTCM is a large and troubled hedge fund. Two of its partners, Robert Merton and Myron Scholes, earned a Nobel Prize in 1997 for their academic work in derivatives. As an academic, Merton argued that derivatives dissipate economic risk, even to the point that hedging techniques using derivatives render equity capital unnecessary to cushion risk.

    Merton and Scholes's own hedge fund seems to have proven this theory incorrect. When Russia defaulted on its debt in 1998, financial market liquidity dried up. LTCM's models and operations assumed that their various hedged positions would be liquid. Illiquid market conditions caused LTCM huge losses, losses so large that the Fed had to arrange for a financial bailout.

    LTCM management drew upon some of the most competent financial mathematicians in the world. While they clearly understood pricing financial instruments, they hadn't adequately studied portfolio risk and capital needs. Had these extremely competent practitioners been trained as actuarial professionals to focus on balancing pricing and capital needs, perhaps LTCM would not have become dangerously leveraged and would have avoided the severe consequences of financial market illiquidity.

    The foundation for expanding the actuarial profession isn't just the effectiveness of actuaries' intellectual tools; our mathematical techniques are accessible and widely used by other competent technicians. What can't be easily duplicated are the advantages to society of a well-established, recognized group of trustworthy and professional financial managers. Professionalism is the unique value we can bring to the financial services industry.

Big Tent Tactics

Tactics for developing a future Big Tent actuarial profession incorporate two important extensions of actuarial work over the past decade: the successful introduction of actuarial techniques to risk pricing and risk management in noninsurance financial institutions, and the growth of new occupations within these institutions filled by high-quality practitioners with strong financial modeling and business skills. As we've seen, we all share a common mathematical basis for our skills. In effect, we are all actuaries.

While actuarial jobs exist today throughout financial services, outside the insurance industry they're not recognized as such. I call these nontraditional practitioners "new actuaries." New actuaries don't yet have a strong sense of professionalism, nor do they have organizations trusted and relied upon by external stakeholders. Absent these attributes, new actuaries won't become fully equipped to handle the fundamental problem of building trust when balancing pricing and capital adequacy.

A Big Tent actuarial profession overcomes these barriers. Under the Big Tent, actuaries will be fundamentally important, trusted and relied upon throughout the financial services industry. To move actuaries toward this vision requires the actuarial profession to pursue three high-level tactics:

  • The first tactic is to embark on redefining and broadening the actuarial education and qualification system to be equally attractive and effective for both current actuaries and new actuaries. We want all risk management professionals to pursue obtaining actuarial credentials.

  • The second tactic is to expand into noninsurance financial institutions by bringing high-qualified, high-visibility "new actuaries" into the actuarial profession. This tactic will probably result in formation of a new actuarial organization for financial actuaries, governed by highly qualified "new actuary" practitioners.

  • While a new actuarial organization for financial actuaries makes sense, the North American profession will need to redesign its existing structure to accommodate our new colleagues.

Reaching toward a vision takes time, a carefully thought-out strategy and clear and effective tactics. The results must be good for all parties affected by vision. The actuarial profession's Big Tent strategy meets these criteria. It's good for all parties. "Professionalism" is a powerful and valuable idea for the practitioner and the public. Actuarial professionals practicing throughout the financial services industry can provide the public with high-quality technical and business advice they can rely on to solve the fundamental problem of balancing competing needs of pricing and capital adequacy with the public interest as their guiding principal. Actuarial professionalism throughout financial service is a good idea whose time will certainly come.

Today's new actuaries, their employers, legislators, regulators and the public at large should easily see the value of actuarial professionalism in creating the trust the financial services industry needs to thrive. Professionalism has made actuaries what we are today. Professionalism is what we actuaries offer to the rapidly evolving world of financial services. Actuarial professionalism will be able to bear the burden of maintaining trust in an increasingly complex global financial services industry.

Howard J. Bolnick is CEO of Radix Health Connection LLC in Chicago and past president of the Society of Actuaries.

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May June 2000 cover

American Academy of Actuaries